When Tax Rates Go Up, The Market Goes...

Doug Short looks at the relationship between tax rates and the market.

From a big-picture perspective, it’s what you would expect: when rates are low, stocks boom (and then bust); when rates are high, stocks tread water.

This is not to say there’s a causal relationship here. As Doug notes, the New Deal was expensive–so taxes had to go up. But the market had to overcome the massive debt binge of the 1920s and the Great Depression.

Similarly, now, the market will have to overcome the debt binge of the 1990s and 2000s, as well as our own crappy economy. At the same time, tax rates will probably go up…

Doug Short: Earlier today CNN Money featured an article entitled Why the deficit will raise taxes. The premise is summarized in the subtitle: The nation’s debt must be brought to heel, and doing so will require tough choices beyond spending cuts, experts say.

Here’s a chart that provides a historical perspective on market performance and federal taxation, which began in 1913. I’ve included only the top and bottom brackets.

The relationship between taxation and the market is controversial. Many people believe that the market is generally helped by tax cuts and harmed by increases. Perhaps there is some truth to this belief.

On the other hand, federal debt can force tax increases on a weakened economy. The S&P Composite had lost over two-thirds of its value in early 1932 when the top marginal tax rate was increased from 25% to 63%. The top rate increased to 79% in 1936, a rate that held through the Great Depression. The New Deal was expensive.

World War II costs triggered additional increases: The top rate jumped to 81% in 1941, 88% in 1942, and 94% in 1944. The top bracket remained above 90% until 1964.

With the Bush tax cuts set to expire in 2010 and the federal deficit skyrocketing, tax increases are probably inevitable.